In order to alert Audit committee members I’m highlighting several examples of potential misreporting using related parties, below. External auditors will not identify some of them as the board will be able to justify through management representations. However, the Audit Committee which is tasked with governance and appropriate financial reporting aspects do not obtain management representations for their purpose. How can they prove that they took due care in the best interest of the company they serve?

#1. Booking certain receipts from a related party as revenues, when in fact, side
agreements obligating the company to repay the funds meant that the receipts were actually
borrowings. The counterparty-companies on these transactions were related parties because executives of the company served on their boards (undisclosed).

#2. Improperly recognized revenue for sales to a distributor controlled by the CEO and CFO, also without disclosing that they were related party transactions. The sales had been made contingent on the distributor reselling the product or returning if unsold.

#3. Recognizing revenue for barter transactions that lack economic substance. A media company can sell advertising services to Company A and buy offsetting services from Company B. Both companies are related parties and no services are actually performed. They’re just book entries inflating both income statements.

#4. The company sells various assets at below-market prices to another company they privately owned and controlled. Relationship is not disclosed and the price can be justified by obtaining a valuation from a third grade friendly consultant.

#5. Sale of non-disclosed real estate assets to the CEO or board members’ relatives, at lower than arms length or fair market prices.

#6. Buying of over-valued assets from related parties and transfer cash to private companies owned by the Executives.

#7. Sale of items to an undisclosed related entity to repurchase them, later. The only purpose of the repurchase was to facilitate the sale.

#8. Payment of consulting fees or other expenses to a related entity without obtaining any service. Money can be easily syphoned from a private related company using a board resolution, taking care of the auditors.

#9. Monies from the public company used to invest in personal or private companies, which lack economic substance. Later, these investments are impaired and written off with the concurrence of the Board.

#10. Granting of loans or leases to undisclosed related parties, by financial services companies, to be impaired soon after due to non repayment. No proper recovery action is taken on such lending.

2 Responses to What can the Audit Committee do about Related Party Frauds?

Suren, all the matters you mention are matters of fundamental integrity; I think an Audit Committee, and even a Board, cannot function effectively when integrity is lacking in people who are influential in the company’s management.

​Where does that get us? I suppose that:

1. Directors must always have their antennae out to sense a lack of integrity. 2. Then, either: 1. deal with the person / people, and rid the company of the root cause, or 2. in a situation where that cannot be done, consider ceasing their associations with the company.

How do audit practices deal with this vexed issue in companies they audit? Do they continue to handle audits even when they know integrity is seriously lacking?

Dear Richard,
Integrity is a function of the environment and culture in which one operates. Behaviours that are not acceptable in UK may be normal practice in Mexico. Your point on auditors is valid. There are auditors who help directors do the above and pretend not to know it. Any of the above can be justified by an intelligent crook? In some cases disclosures in accordance with Standards is also not made, if the relationship is manipulated to be out of scope of the Standard. Globally, there are such cases documented. Generally here- the auditors with integrity insist on disclosures and most of the time “get rotated out” if you know what I mean! Ceasing to be an auditor requires explanations and proving some of these issues may cause more problems than a solution. As you may agree, Auditors cannot stop a transaction that has been carried out with board approval. But the board can.